What is P/E

The ‘P’ stands for the market price of a share and “E” stands for earnings per share. If a stock is trading at 100 a share, and this stock had an EPS of 2.50, then as per formula, the P/E ratio of this stock is 40.

How to calculate P/E

P/E is the relationship between a stock price and the earnings of the company. The P/E can be calculated by dividing the share price with the EPS of the company.

What do we infer from P/E?

P/E gives an idea about what the market is inclined to compensate for a share of earnings of the company. If the P/E is high, the market would be willing to pay more for the company’s earnings. Some investors feel that a stock is over prised if it has a high P/E. It could also mean that the market has high expectations for the future of the and has jacked up the price.

A low P/E could be an indication of a lack of confidence in the stock by the market or it is a stock that has been sleeping and overlooked by the market. Such stocks are known as value stocks and a lot of investors have made huge fortunes from these sleeping stocks before others in the market identified their true value.

What is the right P/E?

There is no right answer as to what is the right P/E. part of the answer will depend on one's willingness to pay for the earnings. The higher price one is willing to pay would mean that the person believes the company has good prospects in the long run, and the higher P/E is right. There will be other investors who may find your value wrong.

More tips on P/E

· If a particular stock has a P/E of 10, it means the market is willing to pay 10 times the earnings. P/E is also referred to as a multiple. The stock in this example has a multiple of 10. It is also denoted as 10x.

· Stocks with potential for good growth will have higher P/E as the investors are willing to buy at a premium with future profits in mind.

· Companies considered as high-risk will usually have low P/E, meaning that the market is reluctant to pay a higher price for the risk.

Is P/E the right formula to value stocks?

P/E as such cannot be considered as the only measure for valuing stocks for the simple reason is that the earnings figures could be skewed due to abnormalities in accounting which could temporarily distort the actual earnings figures. While a low P/E does not mean that a stock is cheap, a high P/E also does not mean that a stock is costly. One has to look at the P/E ratio of the stock in the right context. A buy or sell decision should not be strictly based on P/E, but can be used for getting a better insight into the stock price.

· Different industries have different Ranges of P/E ratios differ from industry to industry that could be considered normal. To give an example, during the years when the IT sector had a boom, IT companies when compared to other sectors had high P/E ratios.

· Sector-wise P/E ratios are available and this helps to locate sectors that are expensive at a specific point in time. To know whether a sector is overpriced, the average P/E ratio of the companies in the industry is compared to their historical average. If the average moves above the historical average, we get the hint that the entire sector is overpriced.

· P/E ratio can be used to compare the prices of stocks in the same sector. If for example the company ABC and company XYZ are both selling at 100 a share, one share may be more expensive than the other depending on underlying profits and growth rates of an individual stock.

What determines the P/E ratio?

The P/E is determined by the following factors such as (1) Expected Growth Rate (2) Risks - Present & Future and (3) Investment needs for the present and future.

(a) Expected Rate of growth – Shares of companies expected to have higher growth rate normally trade at higher P/E multiple, because future earnings are expected to be attractive. When estimated EPS is high, the forward P/E is low when compared with current P/E. So, depending on market information, the share price goes up as investors would be willing to pay a higher price.

(b) Present and Future Risk - Companies that are considered risky usually trade lower, as fluctuations are expected by the market in the operating results of the company. Companies with a high proportion of fixed costs to total costs – (high operating leverage) and high debt/equity ratio – (high financial leverage) are considered to be risky.

(c) Present and Future investment requirement - P/E ratio is affected by the reinvestment requirements of the company. A company with high reinvestment needs is considered to be risky because it would require borrowings by the company This leading to financial leverage or dilution of earnings for shareholders depending on the method of raising funds.

P/E Types

Trailing P/E Ratio is the present market price divided by EPS of the previous year. Forward P/E Ratio is the present market price divided by the estimated EPS for the next year.